A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Wednesday, December 26, 2007

Stimulus Options: Podcast transcript

We thank E.B. for producing the following transcript of the podcast for Wednesday, December 26, 2007.

Last Wednesday at the Brookings Institute, former Treasury Secretary Larry Summers proposed fiscal stimulus for what he saw as a dangerously slowing economy. This in addition to continued Fed interest rate reductions.

Note: E.B. has done a great deal of work in editing that talk, and by eliminating Summers repetitive measured pauses, his liberal use of caveats and some secondary points, the speech has been reduced from over forty-five minutes to sixteen.

We’ll put that up on the Saturday Special in two weeks. This week remember is Chuck Schumer speaking at the same Brookings event.

Here, let’s listen to the pith of Summers, then I’ll come back with some description of the mechanics of stimulus and at least one good idea I haven’t heard so far.

Now here is Lawrence Summers:
If economic data come in as I fear they will, with increasing signs of recession, policy response should include fiscal as well as monetary measures. Fiscal policy can work more rapidly than monetary policy, which has a lag of about a year between a change in the Federal Funds rate and its maximum impact.

Moreover, the efficacy of monetary policy may well be diminished by capital constraints that limit the ability of banks to lend, or creditworthiness constraints that limit the ability of businesses to borrow. As important, the extent to which monetary policy can prudently be used in the current environment is limited by concerns about the dollar as well as about the bubble-creating effect of very low interest rates.

Certain problems, such as the impact of mass foreclosures on affected communities, are not easily amenable to monetary policy.

Fiscal stimulus is therefore potentially critical. But it can be counterproductive if it is not timely, targeted, and temporary. Gene Sperling’s Bloomberg column this week makes these points strongly.

Fiscal policy has to have its impacts in a timely manner.

It has to be targeted to assure that increased government borrowing translates directly into increased spending and demand.

And critically, it has to be temporary, so that its effects are not offset by higher long-term interest rates.

From the point of view of stimulus, the optimal package is one that raises spending and the deficit in the short run while reducing the deficit in the long run, therefore bringing down long-term interest rates.

Stimulus approaching fifty to seventy-five billion dollars, roughly in the range of one-half of one percent of GNP is likely to be appropriate.
Summers specifically supported stimulus in the amount of one-half of one percent of GDP that was quote timely, targeted and temporary unquote and composed of tax cuts, food stamps and unemployment benefit extension.

Republicans are circling any talk of tax cuts for a flagging economy, ready to enlist recession fears in their continuing demands to bring tax rates to zero. Tax cuts are their favorite remedy for all ills.

George W. Bush recommended tax cuts during his first campaign as the correct response to a healthy economy and a surplus in the budget. “After all, it’s your money,” was the campaign slogan. Bush later promoted tax cuts as the necessary medicine for economic weakness. To admit the obvious, the long campaign against taxes has borne fruit. Today taxes are not considered the necessary means of financing public goods, but the teeth of a vampire government. This is a subject for another day, perhaps one day soon. To continue, when the tax cuts of 2001 did not work Bush – along with the compliant Congress – asserted it was because there were not enough of them, and another round came down in 2003. The slogan was not, I should note, “After all, it’s your children’s money.”


All valid stimulus theory follows from the theory of the multiplier, developed by R.F. Kahn in the 1930s and developed and promoted by John Maynard Keynes. The multiplier is at the heart of Keynesian demand side stimulus.

The idea of the multiplier is that an exogenous (outside) spending stimulus will generate much more economic activity than the simple dollar value of the stimulus, because it will echo through the economy. The laborer will buy bread from the baker who will use the money to buy wheat from the farmer who will use the money to buy machinery from the tractor dealer who will use the money to buy meat from the butcher and so on. There is leakage into savings and out of the economy at each step, so the multiplier is not infinite, and may be between two and five, depending on the situation.

Keynes himself proposed public works financed by government deficits as the preferred way of stimulating demand and starting the cycle of jobs and investment. Some time later, Keynesians under John Kennedy proposed a very modest tax cut for the middle class to stimulate the economy of the 1960s. That is, they kept the deficit, but passed the spending along to private households, who bought things and produced some activity. Kennedy’s has been the model for all stimulus programs since.

The multiplier, then, suggests that an exogenous infusion of spending will multiply through the economy and get the providers of goods and services back into forward gear.

Let’s look at five possible stimulus methods.


Reduction of interest rates. This is the monetary version of stimulus The Fed can make money, at least in the short term, cheaper. This encourages investment and spending in theory, which would engage the multiplier, but the idea that it creates strong business investment action is not well supported by evidence. The last time it was tried we got a housing bubble. Business did not invest. Now we have a huge inventory of energy-inefficient houses, millions of people in financial distress, a credit market dysfunction and a huge debt overhang. This suggests that now, even if money were free, the tendency would be to hold onto it rather than invest.


Tax cuts for the rich.

This has been tried a couple of times. Once under Ronald Reagan and more recently, of course, under George W. Bush. In both instances the economy was not stimulated, as the wealthy simply added the bonus cuts to their wealth and continued to spend as before. This suggests the second of Larry Summers trinity TARGETED, where the tax cuts go to those who will spend, and thus at least start the multiplier.


Tax cuts for the poor or across the board.

The lower the income, the higher the tendency to spend. So if tax cuts are stimulus policy, the lower on the income ladder, the more effective at least for the first round. An interesting parallel exists with inflation. Just as the multiplier differs for different income classes and goes up as you go down the income scale, the same is true of recent inflation. Food and fuel comprise a higher proportion of purchases at the lower end. When you throw in the double digit rises in health care you find that in times such as ours, the effective inflation rate is much higher at the bottom.


Tax cuts for targeted business investment

A way to leverage a higher exogenous stimulus would be to offer tax cuts to business investment. If business moved investment forward or made a yes rather than a no decision on an investment decision as a result of tax incentives, a greater initial boost would follow creating a greater total stimulus. There is, please note, no essential difference between government deficit spending and business investment whether financed by investment or debt. They are both exogenous and stimulative.

The major problem with this scheme is it doesn’t work very well. Businesses may move around investment decisions, but their basic calculus is not changed. They invest when they see an opportunity for profit, not because money is cheap or costs are less. In a flagging economy, profit opportunities may not be very clear.


Public spending on public works.

This was the method preferred by Keynes. Producing public works means you hire somebody up front. His or her paycheck is the means of getting the spending into the private economy. One big advantage is that there is no leakage in the first round, thus the multiplier is greater for the same spending. That is, one hundred percent of the initial spending goes to employment, whereas in tax cuts the recipients may save some portion and will very likely spend at least a little of the rest on goods that generate overseas employment rather than American.

The second major advantage of public works spending is you have the public work when you are done. A road or sewer will yield benefits far into the future for the society that the purchase of a lawn mower will not.


How do these rate on efficacy? And how do Summers Timely, Targeted and Temporary criteria apply?

But first, notice that the multiplier works with negative numbers, too. If for some reason spending is subtracted from the economy, the effect is far more dire than the simple dollar value of the initial subtraction. Ask any community faced with the closure of a plant or military base.

But second, Let us see what goods comprise the initial round of spending. With tax cuts, many people get a relatively small bonus to spend, and that which is not saved goes for consumer goods, discretionaries or necessities at the margin, depending on the income level. With tax cuts for business investment, providing new investment is leveraged, it goes for the range of plant and equipment or R&D and this includes many payroll jobs. Public works is a similar mix.

But third, just be aware that any stimulus, by definition, must be deficit financed. If we rob Peter to pay Paul, the community which includes them both is no better off. So with stimulus we are indeed intending to add to the deficit, all other things equal.

So efficacy?

Interest rate reductions?

Are we really going to restart a housing boom? Is business going to invest in this economy, particularly considering the seizing up of the credit markets we are currently witnessing? Low rates are better than high rates, but the financial markets have a lot of self-repair to do before there is any help from that direction.

Timely? Even aside from the problematic nature of the financial sector, interest rate reductions take twelve to eighteen months to be effective. Knowing how much is enough is very difficult when the results are that far out.

Targeted? As mentioned, last time interest rates were used as the primary stimulus method, housing boomed. It is hard to think that this was the intention, since business investment is always on the front of every policy presentation.

Temporary? Who knows? Interest rates also double as the main inflation-fighting mechanism. That promotes ... well, volatility.

Tax Cuts


Tax cuts can be instituted very quickly by reducing withholding rates. So something, perhaps not a great amount, could be done almost immediately.


Across the board cuts as would likely be used disproportionately benefit the wealthier. According to the Congressional Budget Office, roughly 85 percent of income from all sources goes to the top half of Americans. This is the wrong target. A cut in payroll taxes is not appreciably less biased, with about 80 percent in the upper half. Tax cuts would thus produce more spending on consumer discretionaries after an initial round of leakage (which would be significant, since savings are encouraged in the present consideration).


As Summers has noted, the tax cuts of 2001 and 2003 have been very sticky.

Business Tax Cuts to Stimulate Investment


New business investment does not respond very quickly or directly to tax cuts. As before, prospects of profit far outweigh tax considerations. Evidence is strong that investment decisions already made can be moved forward, but this may not bode well for later time periods, even if the cuts are NOT temporary.


The target is clear. The question is whether tax cuts for business ever reach that clear target. Evidence is not good except in extreme cases, such as some of the Reagan tax incentives of the early 1980s which at times actually made investment cost less than nothing. Note that this tended to promote investments into the favored types, decisions that may have been out of step with overall strategy and so less useful to the business and to the economy.

In the first round, the composition would be more or less productive investments and jobs. This is significantly different than consumer discretionaries. Jobs provide more income to less people than individual tax breaks, but the next round of spending is not focused on discretionaries or at the margin, but across the board, to housing, utilities and the rest of personal consumption.


These sorts of tax cuts have also been somewhat sticky, tending to outlast their original intention, and drawing businesses to depend on them.

Public Works


New public works projects would likely not start until after the need for stimulus was past, considering the need for design and site preparation and so on. Public works already underway could be accelerated, perhaps, or those on the shelf implemented somewhat more quickly. When Keynes developed the theory, the recession in question was a matter of years, not a few quarters.


Again, as with business investment, in addition to the actual public work and materials for it, the target would be the range of personal consumption expenditures, as it would produce jobs, not bonuses to existing workers.


Public works, once completed, provide ongoing public benefit with no ongoing cost. Any particular project, however, could extend into years before completion.

This discussion shows that none of the alternatives is very efficient, but the context of recession on the ground suggests another course. Tax receipts for state and local governments fall during recession, often because they are dependent on sales taxes, but in the current case also because property values are falling.

Since these levels of government do not have the luxury of deficit spending, reducing their revenue reduces their expenditure, and the situation of negative numbers referenced above occurs. That is, the multiplier is employed in reverse. A federal stimulus program might simply offset this contraction.

An alternative would be for the federal level to provide stability to the economy by supporting the state and local levels, mitigating their contraction. Further, this is a direct conduit to public works, since most public works are managed by these lower levels. Support through this channel has a better chance of finding useful projects that can be accelerated, implemented quickly, or just not shelved.


This would be immediate


Public services, public works. These are jobs, thus the range of personal consumption expenditures is wide. Notably the number of employees in the upper quintile would be fairly small.


As property tax and other revenue recovers, the need for federal assistance would be reduced. This would be relatively easy to see and document.

We apologize for the length of this podcast. Providing stimulus in the context of an ongoing and deepening federal deficit has its own dangers we did not mention. Thursday we’ll take a more direct look at this question and possibly another benefit for public works.